identifying and assessing risks of material misstatement due to fraud or error

7/26/2019 Identifying and Assessing Risks of Material Misstatement Due to Fraud or Error

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IDENTIFYING AND ASSESSING RISKS OF MATERIAL MISSTATEMENT DUE TO

FRAUD OR ERROR

Risk of material misstatement refers to the risk that the nancial statements are

materially misstated and do not present true and fair view. To provide a basis for

designing and performing further audit procedures, the auditor shall identify and

assess the risks of material misstatement at two levels:

• The nancial statement level; and

• The assertion level for classes of transactions, account balances, and

disclosures.

Financial Statement level vs. Assertion level

Financial Statement Level Assertion LevelRefers to risks that relate pervasively to

the nancial statements as a whole andpotentially aect many assertions.

Risks of this nature are identiable with

specic assertions at the class of transactions, account balance, or

disclosure level.actors aecting the risks:

• !anagement"s #ntegrity

• !anagement"s e$perience and

knowledge

• %ressure on !anagement

&ature of entity

actors aecting the risks:

• 'usceptibility of account

• (omple$ity of transactions

Transactions not sub)ect to

routine processing

#n identifying and assessing risks of material misstatement, the auditor should

a. Identi! ris"s throughout the process of obtaining an

understanding of the entity and its environment, including

relevant controls that relate to the risks, and by

considering the classes of transactions, account balances,

and disclosures in the nancial statementsb. Assess t#e identi$ed ris"s, and eval%ate &#et#er

t#e! relate more 'ervasivel! to t#e $nancial

statements as a &#ole and 'otentiall! a(ect man!

assertions;c. Relate t#e identi$ed ris"s to &#at can )o &ron) at

t#e assertion level, taking account of relevant controlsthat the auditor intends to test; and;d. *onsider t#e li"eli#ood o misstatement, including

the possibility of multiple misstatements, and whether the

potential misstatement is of a magnitude that could result

in a material misstatement.

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Identi$cation o Ris"s

#nformation are gathered by performing risk assessment procedures. These

information, including previous information obtained in evaluating the entity, its

environment and its design of controls, form part of the audit evidences to support

the risk assessment. The risk assessment determines whether further procedures

are to be performed, as well as its nature, timing, and e$tent.

(ertain conditions and events may indicate an e$istence of risks of material

misstatement. These can be found in Appendix 2 of %' 012 3Redrafted4. 'ome of

these are:

• 'ignicant changes in the entity 3e.g., ac5uisitions and reorgani6ations4

• 'ignicant changes in industry

• 'ignicant new products, services or lines of business

• &ew locations

• 'ignicant changes in #T environment

• -perations in areas with unstable economies

• 7igh degree of comple$ regulation

Assessin) Identi$ed Ris"s

Risks must be identied whether they aect pervasively the nancial statement as

a whole or pertaining to specic transaction, account, or disclosure to determine the

potential risks and the re5uired treatment.

The auditor may identify the controls that are likely to prevent, or detect and

correct, material misstatement in specic assertions. #dentied risks must be

related to 8what can go wrong"s9 and it must be determined how they are relatedwith relevant controls. 'ome controls must be related in the conte$t of processes

and systems in which they e$ist because individual control activities often do not in

themselves address a risk. or e$ample, centrali6ed processing and control, used to

prevent incorrect information from appearing in the nancial statements, may

consist of several components such as an ecient (omputeri6ed #nformation

'ystem, rotation of employees involved in recording transactions, enforcement of

ethical standards via reward system, etc.

-ther control activities, however, may have a specic eect on an individual

assertion embodied in a particular class of transactions or account balance. or

e$ample, the control activities that an entity established to ensure that its

personnel are properly counting and recording the annual physical inventory relate

directly to the e$istence and completeness assertions for the inventory account

balance.

(ontrols can be either directly or indirectly related to an assertion. The more

indirect the relationship, the less eective that control may be in preventing, or

detecting and correcting, misstatements in that assertion. or e$ample, a sales

manager"s review of a summary of sales activity for specic stores by region



ordinarily is only indirectly related to the completeness assertion for sales revenue.

ccordingly, it may be less eective in reducing risk for that assertion than controls

more directly related to that assertion, such as matching shipping documents with

billing documents.

MISSTATEMENTS

s dened in %' 2<, +Misstatement is a di(erence ,et&een t#e amo%nt-

classi$cation- 'resentation- or disclos%re o a re'orted $nancial statement

item and t#e amo%nt- classi$cation- 'resentation- or disclos%re t#at is

re%ired or t#e item to ,e in accordance &it# t#e a''lica,le $nancial

re'ortin) rame&or"./

!isstatements may emanate from:

• +rror

• raud

• &oncompliance with =aws and Regulations

ERROR

+rror refers to unintentional misstatements in the nancial statement such as:

• !athematical or clerical mistakes in underlying records and data

• -versight or misinterpretation of facts resulting in incorrect estimates

• !istakes in application of accounting policies

FRAUD

raud refers to intentional act by one or more individuals among management,

those charged with governance, employees, or third parties, involving the use of

deception to obtain an un)ust or illegal advantage. The auditor is primarily

concerned with fraudulent acts which cause material misstatements in the nancial

statements.

raud in uditing may be divided into:

• raudulent inancial Reporting

• !isappropriation of ssets 3*efalcation4

Fra%d%lent Financial Re'ortin) involves intentional misstatements or omissions

of amounts or disclosures in the nancial statements to deceive users. This is also

known as 8management fraud9 because it usually involves members of

management or those charged with governance. This may involve:

• !anipulation>falsication>alteration of records or supporting documents

• !isrepresentation or intentional omission of events or transactions



• #ntentional misapplication of accounting policies

Misa''ro'riation o Assets involves theft of an entity"s assets committed by the

entity"s employees. #t is also known as 8employee fraud9. This is usually

accompanied by false or misleading records to conceal theft. This may include:

• +mbe66ling receipts• 'tealing entity"s assets 3cash, marketable securities, inventory4

• =apping of accounts receivable

NON*OM0LIAN*E 1IT2 LA1S AND REGULATIONS

Noncom'liance &it# La&s and Re)%lations is the omission or commission by

an audit?client contrary to prevailing laws or regulations. This includes:

• Ta$ evasion

• @iolation of environmental protection laws

• #nside trading of securities

AUDITOR3S RES0ONSI4ILITY

The following lists the overview of the steps to be taken to treat misstatements.

#n cases of error and fraud

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o !ake in5uiries of management

o *esign audit procedures based on risks

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o %erform assessment procedures

o ssess if fraud or error

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o -btain management"s written representation for its responsibilities

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o uditor may re5uest revision of '

o uditor may either 5ualify or disclaim his opinion

#n cases of noncompliance

•

%=&&#&/o -btain general understanding of legal and regulatory framework

o *esign procedures to identify noncompliance and evidences of

compliance

• T+'T#&/o +valuate possible eects on '

o *ocument ndings, discuss with management, and consider

implications



• (-!%=+T#-&

o -btain management"s written representation for its responsibilities

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o uditor may re5uest revision of '

o uditor may either 5ualify or disclaim his opinion

SIGNIFI*ANT RISKS5 Ris"s t#at Re%ire S'ecial A%dit *onsideration

'ignicant risk is an identied and assessed risk of material misstatement that, in

the auditor"s )udgment, re5uires special audit consideration.

The auditor shall determine whether any of the risks identied are, in the auditor"s

)udgment, a signicant risk. #n e$ercising )udgment as to which risks are signicant

risks, the auditor shall consider at least the following:

• Bhether the risk is a risk of fraud;

•

Bhether the risk is related to recent signicant economic, accounting orother developments and, therefore, re5uires specic attention;

• The comple$ity of transactions;

• Bhether the risk involves signicant transactions with related parties;

• The degree of sub)ectivity in the measurement of nancial information

related to the risk, especially those measurements involving a wide range of

measurement uncertainty;o ccounting principles for accounting estimates or revenue recognition

may be sub)ect to diering interpretation.o Re5uired )udgment may be sub)ective or comple$, or re5uire

assumptions about the eects of future events, for e$ample, )udgment

about fair valuend;

• Bhether the risk involves signicant transactions that are outside the normal

course of business for the entity, or that otherwise appear to be unusual.o /reater management intervention to specify the accounting treatment.

o /reater manual intervention for data collection and processing.

o (omple$ calculations or accounting principles.

o The nature of non?routine transactions, which may make it dicult for

the entity to implement eective controls over the risks.

identifying and assessing risks of material misstatement due to fraud or error

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